On March 11, 1997, the Department of Education convened a meeting with approximately 20 members of the postsecondary education community to discuss proposed rules for financial responsibility. This meeting was a follow-up from the meeting on February 5, 1997, and included many of the same representatives from institutions and postsecondary associations. The meeting was organized to provide a progress update since the last meeting and to continue to discuss issues that have been raised in previous meetings and through public comment. The following is a brief summary of the issues that were discussed at the meeting.

David Longanecker began by indicating that the Department needs rules of financial responsibility for three reasons. He indicated that the statute, as currently written, requires the Department to create financial responsibility standards that ensure that participating institutions are financially capable of providing the services they contract to offer as well as the administrative support to carry out those services. He also said that the Departments oversight experience shows that a significant percentage of potentially troubled institutions -- as much as one-third of the public and proprietary institutions and one-half of the private non-profit institutions that are currently being informally tracked -- are in such condition because of inadequate financial resources. Finally, Dr. Longanecker said that recent changes in accounting standards have made it necessary that we revise the current standards.

Jamie Studley, the meetings facilitator, outlined the agenda for the meeting and gave an overview of the work that has been done by the Department and KPMG Peat Marwick since the last meeting. She indicated that the Department and KPMG have (1) reviewed additional financial statements from recent years; (2) created a database to begin analyzing financial statements from institutions that have closed in order to better understand how such schools would score under the ratio methodology; (3) continued to meet and discuss issues with members of the higher education community to obtain comments and suggestions, including a meeting on February 27 with proprietary school owners and accountants representing individual institutions, chains, and approximately 100 client institutions; and (4) constructed and considered possible alternatives to the proposed ratio methodology that reflect comments and suggestions received.

Ms. Studley stated that the Department is working to change the current standards of financial responsibility because, based on its experience with the current regulations, the Department believes the rules can be improved to create standards that (1) reflect recent accounting changes; (2) better differentiate among the sectors to reflect business differences and capital structure; (3) are less susceptible to manipulation; and (4) provide a better picture of an institutions total financial situation by using a blend of financial factors consistent with reasonable business decision making.

Ms. Studley provided categories and data to help quantify the potential magnitude of Federal funds at risk due to a lack of financial resources at participating institutions, including losses at institutions that have closed, liabilities in final program review determinations that might be attributed to inadequate financial resources, and costs in terms of students investment in education that is sacrificed when schools cannot afford to provide minimum services or close before the student completes his or her program. Both the closed school and program review data include institutions from all sectors.

The Higher Education Act contains a discharge provision for loans made to students who attend institutions that close before the students program is completed. According to data in the National Student Loan Data System, in 1995 and 1996, $62 million of loans were discharged for 18,000 students because the schools that those students attended closed, representing potential losses for the federal government. In addition, failure to act as a fiduciary of Title IV funds is indicated in program review findings. One measure of the amount of Title IV funds at risk is the amount of program review liabilities levied. Over the past five years, nearly $700 million of program review liabilities have been assessed against institutions. Although, the precise reason for the school closings and the program review findings are not delineated further, the Department believes that an appreciable percentage of institutions that close did so because of financial problems and that a significant amount of program review liabilities were the result of administrative shortcomings brought about by financial difficulties.

KPMG distributed materials to the participants and introduced issues that the group discussed in more detail. KPMG Partner Herbert Folpe summarized work KPMG has done since the last meeting, including performing additional empirical testing on nearly 1,000 financial statements, meeting with many school representatives, researching various ratio analysis theories, and analyzing financial statements from closed schools.

EQUITY RATIO AND VIABILITY RATIO. Mr. Folpe indicated that in response to many comments regarding the viability ratio, KPMG has seriously explored the possibility of either replacing the viability ratio with an equity ratio or adding the equity ratio so that the methodology would include four ratios. The equity ratio, defined as net assets divided by total assets for private non-profit institutions, and net worth divided by total assets for proprietary institutions, would add an institutions investment in property and equipment into the methodology, factors excluded in the three ratios proposed in the NPRM. The equity ratio gives credit to an institutions investment by including fixed assets in the calculation.

KPMG asked for input regarding the value and appropriateness of the equity ratio and whether participants thought that it should replace the viability ratio or be added to the methodology as a fourth ratio. In addition, KPMG asked whether adjustments should be made for intangible assets and permanent endowments.

Many participants stated that incorporating the equity ratio into the methodology provides a more comprehensive picture of an institutions financial condition. Others suggested that since the primary reserve ratio measures liquidity, the viability ratio is somewhat redundant and could be replaced. Furthermore, the adjustments for institutions with no debt would be unnecessary if the viability ratio is eliminated from the methodology.

KPMG also asked the group for input on potential strength scores with regard to the equity ratio. It provided initial data indicating that a sample of nearly half of all proprietary institutions with NPRM composite scores below 2.00 have equity ratios near 15 percent, signifying that potentially weak institutions are thinly capitalized. A similar sample of private non-profit institutions indicates higher levels of equity. KPMG indicated that it is considering the following strength factors ranges for the equity ratio after deducting intangibles and permanent endowment from the calculations:

Private Non-Profits

Strength Factor Score

1

3

5

Equity Ratio

0.15

0.35

0.55

Proprietaries:

Strength Factor Score

1

3

5

Equity Ratio

0.10

0.30

0.50

KPMG indicated that these strength factor scores are extremely preliminary and stressed the need for the community to provide suggestions and comments on what it thinks are appropriate break-outs. In response to a question about the effect of dropping the viability ratio from the methodology, KPMG commented that, for institutions with a material level of debt, the viability ratio and primary reserve ratio correlate to a certain degree.

INTANGIBLES AND ENDOWMENTS. With respect to intangible assets and endowments, some participants indicated that they should be included in the equity ratio. Specifically, it was suggested that goodwill, which can be acquired when an institution buys another institution, should not be deducted from net worth, as it is in everyones interest for good and financially healthy schools to take over bad and financially-troubled schools.

Comments were provided that the methodology could "haircut" goodwill, i.e., give full credit for goodwill in the first year and then reduce it in future years by a percentage that may be higher than the institutions amortization. KPMG stated that any increased amortization of goodwill over the institutions own amortization schedule would not be reflected in the primary reserve ratio. KPMG also suggested that the methodology could cap goodwill at a percentage of total equity. This would in part address the concern that many schools do not carry goodwill on their books, and therefore by increasing strength scores across the board to reflect this additional resource at some institutions might not be equitable. Several participants agreed that this is an important issue to consider. KPMG said that it would consider the percentage of the institutions that have goodwill as part of its analysis.

NET INCOME RATIO. One participant suggested that more weight be put on the net income ratio for private non-profit institutions. KPMG indicated that substantial increases in net income for private institutions may reflect schools implementing FASB 117 and 124. KPMG indicated that it thought net income for this sector should be weighted rather lightly because of the volatility of investment returns which are directly reflected on the institutions income statement. Other participants seemed to agree that where net income is largely dependent on market returns from endowment, it should not be given substantial weight.

OTHER STRENGTH FACTORS AND WEIGHTINGS. KPMG indicated that it is considering lowering the strength factors proposed in the NPRM based on the empirical data. Specifically, after analyzing more financial statements, the impact of private colleges adopting FASB 116 is not as significant as expected, especially for institutions that have little or no endowment. KPMG suggested that the strength factors for the primary reserve ratio and net income ratio be moved back to the fund accounting levels that were proposed for private non-profit institutions that had not adopted FASB Statements 116 and 117 in the NPRM. In addition, KPMG is considering, based on public comments and significant discussion from the February 27 meeting with the proprietary institutions, lowering the weight of the net income ratio for the proprietary institutions as well as lowering the strength factor thresholds for the net income ratio to incorporate net losses.

COMPOSITE SCORE SCALING. KPMG indicated that many comments were received about a "cliff effect" in the NPRM composite scoring process. For example, a private non-profit institution (under FASB 116/117) with a primary reserve ratio of 0.3 would receive a score of 3 for that ratio, yet an institution with a primary reserve ratio of .29 -- a very small difference -- would receive a score of 2. KPMG said that it is considering different options to lessen the burden of slightly falling below strength factor thresholds.

One alternative is to add significantly more thresholds, as many as 50 more, to strength factors between one and five. This could work similar to existing tax tables. Another alternative, which seemed to many participants to be easier to understand, is to create a linear algorithm that would reflect the slope of a straight line. In a related vein, strength factors could be revised to range from zero to five (instead of from one to five). This would allow for more differentiation at the bottom end of the scale which, the Department and KPMG indicated, could also be used by the Department to better target its oversight resources on at-risk institutions. Many participants suggested that these were good alternatives and agreed with the Department that ease of understanding is an important consideration in evaluating any alternative.

The Department and KPMG also suggested possible changes to the ratio methodology's scaling mechanism. Because greater definition is needed at the lower end than on the higher end of the scale for purposes of these regulations, it would be possible to rescale or reduce the number of strength factors, and truncate the assignment of composite scores, at the high end of the scale. By eliminating ordinal rankings at the high end of the scale, these adjustments could potentially eliminate concerns in the higher education community that data derived from the ratio methodology could be used for purposes for which the methodology is not intended. The Department indicated that it would consider this option in conjunction with its desire to create a differentiated system of statutory and regulatory relief based on administrative performance.

Z-SCORE. KPMG indicated that it is comparing its ratio methodology with the z-score methodology, a similar form of ratio analysis that is widely used as a predictor of bankruptcy in the manufacturing sector. KPMG explained that the z-score is a five-factor methodology that includes a measure of sales to total assets and is more appropriate, with respect to postsecondary education, to the proprietary sector than any other sector. It was noted that many representatives from the proprietary sector thought the z-score methodology was too complex. It was also noted that the calculation of the z-score requires elements not available on general purpose financial statements.

SECOND TIER ANALYSIS. Participants suggested that secondary or supplementary measures be incorporated into a final rule for institutions that fail to meet the composite score threshold indicating financial responsibility. Some participants stated that the nature of any secondary measures depends on where the "bright line" is set. KPMG and the Department indicated that the NPRM afforded an institution that received a composite score less than the "bright line" with the ability to continue to participate in the Title IV programs under certain circumstances. KPMG also suggested that almost all of the previous suggestions for supplementary considerations centered on equity. If the equity ratio is added to the methodology, these concerns may be alleviated. The Department and KPMG asked the participants for more comments and suggestions in this area.

Some participants suggested that the Department look carefully at creating a range of different kinds of requirements that it could place on institutions that failed the ratio methodology, including those that failed any type of possible secondary analysis. These participants suggested that there should be a range of requirements or sureties that the Department would allow these institutions to meet and continue to participate, a range which would be based on their level of risk, and which would be less stringent than the 50% letter of credit, provisional certification, or the proposed precipitous closure alternative. Representatives of the Department replied that while the focus of this meeting was on the proposed ratio methodology itself, the Department was also continuing to evaluate comments on the proposed alternatives within the framework of statutory requirements.

"BRIGHT LINE." Some participants asked whether KPMG and the Department have considered lowering the 1.75 composite "bright line" score. KPMG indicated that it has considered lowering the score slightly but stressed that setting the "bright line" will depend on many factors that are still under consideration. Specifically, the "bright line" will need to take into account whether the equity ratio is added to the methodology and whether it replaces the viability ratio or acts as a fourth ratio; whether the equity ratio incorporates intangible assets and permanent endowment; whether the methodology incorporates a linear component that alleviates possible distortions of a "cliff effect;" whether strength factors are relaxed to reflect the fund accounting ranges proposed in the NPRM; and whether strength factors are changed so as to range from zero to five (or zero to three) instead of from one to five.

AVAILABILITY OF DATA. KPMG and the Department agreed to disseminate strength factors and weighting of ratios under consideration on the world wide web. KPMG offered possible strength factors for the equity ratio during the meeting (see above). KPMG and the Department continued to ask the participants for comments and suggestions on possible strength factors and appropriate weights, and they stressed that the community need not wait for more information to be distributed before they provide suggestions.

ROUNDING TO TENTHS. KPMG and the Department asked whether the methodology would be made simpler or more understandable if the calculations and strength factors were restricted to tenths (i.e., one decimal point) rather than hundredths (i.e., two decimal points) as has be used thus far. Several participants stated that this would be a positive change.

TREND ANALYSIS. Comments were provided that a trend rather than a snapshot approach would generate a more accurate picture of an institutions financial health. KPMG indicated that the ratio inherently reflects prior performance. There were also concerns raised that trend analysis does not always indicate whether an institution is truly on a downward trend or if it is experiencing a temporary adjustment. In hindsight, it might be evident, but the Department would nonetheless face the potential problem of interpreting three years of an institutions steady performance followed by a moderate loss. KPMG also suggested that trend analysis could be added to the methodology, particularly with respect to the net income ratio, in the future.

PUBLIC INSTITUTIONS. Some participants asked about the treatment for public institutions. KPMG indicated that it has done limited analysis of public institutions. The Department said that it would organize a meeting with representatives of public institutions in the very near future to discuss how the rule will affect public institutions. The Department indicated that any relaxation of the rules for public institutions would not relieve them from the requirement to provide annual financial statements. Participants commented that the final rule should be more specific about what constitutes "full faith and credit" to account for the potential weakness of the supporting governmental entity. Similarly, the Department should have the flexibility to consider whether the supporter is financially healthy and has taxing authority. Another participant suggested that the Department analyze the bond ratings of public institutions as well as the bond rating of the affiliated state governments.